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Last Updated : Jul 25, 2012 04:32 PM IST | Source: equitymaster.com

The basics of price to book value (P/BV)

The price to book value (P/BV) ratio is a widely used valuation parameter used for valuing stocks. But what does P/BV mean and how can investors use this parameter to value their investments? In this article, we will try and simplify this concept.

 
 
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The price to book value (P/BV) ratio is a widely used valuation parameter used for valuing stocks. But what does P/BV mean and how can investors use this parameter to value their investments? In this article, we will try and simplify this concept.

How is price to book value calculated?

P/BV is arrived at by dividing the market price of a share with the respective company's book value per share. Book value (BV) is equal to the shareholder's equity (share capital plus reserves and surplus). BV can also be derived by subtracting current and non-current liabilities from total assets. For the banking and finance companies, book value is calculated as 'share capital plus reserves minus miscellaneous assets not written off. This formula then takes care of the bank's NPAs (non performing assets) and gives a correct picture.

Let us take up an example and calculate the latest book value Infosys.

FY12 Balance sheet of Infosys

LiabilitiesRs bnAssetsRs bn
Equity capital3Cash206
Reserves & surplus310Other current assets97
Current liabilities69Fixed assets61
Non-current liabilities4Non-current assets17
  Deferred tax assets5
 386 386

 

 

 

 

 

 

 

 

If one were to take a look at Infosys' consolidated balance sheet for FY12, as mentioned above, book value will be arrived at by adding Rs 3 bn (equity capital) and Rs 310 bn (reserves and surplus), which equals to Rs 313 bn. Conversely, when we deduct current and non-current liabilities from total assets, we shall arrive at a similar figure. Now, by dividing this book value (Rs 313 bn) by the issued equity shares of the company (approx 574 m), we would arrive at the book value per share figure, which is Rs 545. This will be our denominator for calculating the P/BV for the Infosys stock, which currently stands at about 4.5x (at market price of Rs 2,438).

What does P/BV indicates?

Usually, P/BV figures for companies in the services industries like software and FMCG are high as compared to those of companies in the sectors like auto, engineering, steel and banking. This is due to sectors such as software and FMCG have low amount of tangible assets (fixed assets etc.) on their books and therefore, the P/BV may not be a correct indicator of valuation. On the other hand, capital intensive businesses such as auto and engineering require large balance sheets, i.e., they have a large amount of fixed assets and investments. P/BV is a good indicator of measuring value of stocks from such capital intensive sectors.

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If a company is trading at a P/BV of less than 1, this indicates either or both of the two-

  • Investors believe that the company's assets are overvalued, or
  • The company is earning a poor return on its assets.

A high P/BV indicates vice versa, i.e., markets believe the company's assets to be undervalued or that the company is earning and is expected to earn in the future a high return on its assets. Book value also has a relationship with the Return on Equity of a company. In fact, book value can also be termed as equity (equity capital plus reserves and surplus). As such, for a company that earns a high return on equity, investors would be ready to give the stock a high P/BV multiple.

What does P/BV fail to indicate?

P/BV indicates the inherent value of a company and is a measure of the price that investors are ready to pay for a 'nil' growth of the company. As such, since companies in the services sectors like software and FMCG have a high growth component attached to them, Price to Earnings ratio (P/E Ratio) would be a better method of gauging valuations.

Investors would do well to note that P/BV should not be used for valuing companies with high amount of debt. This is because high debt marginalizes the value of a company's assets and, as such, P/BV can be misleading.

We hope this article was able to throw some light on the concept of P/BV and its relevance from an investor's viewpoint. The ratio has its shortcomings that investors need to recognise. However, it offers an easy-to-use tool for identifying clearly under or overvalued companies.

Equitymaster.com is India`s leading independent equity research initiative

First Published on Jul 13, 2012 03:36 pm
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